It’s the economy, stupid

At Tricio we focus on economic cycles, market structures and investor behaviour in order to help clients navigate markets with a medium to long-term investment outlook.

Global markets are being roiled by the US (and Israel) attack on Iran. The vast majority of the conflict and casualties have been in Iran, but Iran has spread the war to its neighbours and of course, the Strait of Hormuz. US President Trump won’t be happy with stock market reactions to his war this week if shares tumble by 10% or more. The reaction last week was relatively muted in the US, with oil importing countries like South Korea and Japan seeing more equity market losses (to be fair, they had risen a lot since the start of the year as well).

We posted a podcast last week where we discussed our thoughts, and have published various blogs on some markets as well. The surprise is still the reaction by bond markets – spooked by the Russian invasion of Ukraine in 2022 – which are seeing yields rise in the US, UK and Europe as traders price in rate hike risk by the ECB this year and reducing or taking away rate cut bets in other countries. The extent to which higher energy prices lead to persistent inflation depends on lots of different things. This is not a pure play inflation play though, as stocks generally do ok in inflationary periods – but again, 2022 stands out as a year in which stocks tumbled for much of the year.

Given that so much depends on how higher energy prices go and more importantly, for how long, investors will be looking for clarity from US President Trump sooner rather than later. His administration spokespeople are not inspiring confidence, and this is likely to remain the case. The war is not popular in the US as most polls suggest that people are confused as to why this happened now. If the US was really interested in ‘pay back’ for previous conflicts with despotic nations, surely Trump would not have been so chummy with the North Korean leader in his first administration? Technically, the US is still at war with N. Korea, they have lots of missiles aimed at key allies and have developed the ability to strike the US and have nuclear weapons. And there’s the rub.

Our best guess is that Trump will declare victory once he thinks that Iran’s nuclear capability has been degraded again, and that their overall military has been substantially weakened. Regime change and inciting the population or ethnic groups to attempt a revolution may take a backburner to the reality of a ground war being difficult, and costly. Amidst the fog of war, Iranian missiles and drones are doing damage to US air defences in the Gulf. Meanwhile the Iranian regime seems to be digging in.

But what if Trump doesn’t back off? There are scenarios where continuing bombing with various ‘boots on the ground’ to either support some groups or to take key facilities could unfold. The conflict could last through the summer and into year-end (or longer). We don’t favour this but it is worth considering. Traders have marked up non-energy commodity prices already and may continue to do so, citing trade route disruptions and higher input costs. Food, fertilizer, everything could be marked up. Hence the reaction by bond markets.

This could hit real economic activity particularly in the UK, Europe and Asia and even the US. While the narrative has been that the US is relatively energy independent and won’t be that affected, the bond market is saying otherwise, and stocks may do the same this week.

Even if the war drags on the heavy US investment spending on the AI build-out will not slow down soon, at least not this year. Meanwhile defence spending is on the up and the tariff tax has been reduced. So the risk of an overheating US economy has probably risen, especially given the possibility of new fiscal spending as the midterms approach.  Against that, a significant fall in US stocks, if seen, could hit consumer spending, reducing overheating risks.

Oil prices will be key in all this. Reports of oil production shutdowns in the Gulf sent oil prices soaring over the weekend. Although the US is self-sufficient, high prices hit consumers and sentiment, even if the producers rake in high profits. For oil-importing countries the impact is greater of course. Meanwhile, higher natural gas prices are bad news for Europe and Asia, though the north American gas market, largely pipe-line supplied is hardly affected.

For most investors, wait and watch is likely the best strategy. An end to the war could see stocks leap higher, making sales now risky, as long as investors are in for the long term. But there could be buying opportunities in coming months, particularly if the war goes long. Much depends on President Trump calling time on his war. The Clinton campaign quip from James Carville in 1992 ‘It’s the economy, stupid’ could become important ahead of the midterms if this war persists.

For further information on our research insights and our ‘Ask a Buddy’ CIO service please contact us at info@tricio-advisors.com